The Morneau Massacre of 2017

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If you’ve just returned from vacation and wondering what’s new in the tax world, you’d better sit down and take a pill. On July 18, finance minister Bill Morneau rolled out the federal government’s proposals designed to “close loopholes and deal with tax planning strategies that involve the use of private corporations”. In short, Finance is proposing to tax an axe to many of the tax strategies that have been available to small business owners and professionals up until now.

The proposals are complex, comprehensive and wide-ranging, covering the following main areas of tax planning:

  • Income sprinkling
  • Multiplication of the capital gains exemption
  • Converting a private corporation’s regular income into capital gains
  • Holding investments inside a private corporation

Income Sprinkling

This strategy involves the splitting of income to take advantage of lower marginal tax rates available to family members. Many rules have been put in place over the years to curtail this practice. Most notably, the tax on split income (TOSI), or “kiddie tax” applies the highest marginal tax rates to certain dividends paid to minor children.

With the new proposals, the TOSI will no longer be limited to minor children. Complex new rules will apply the TOSI to dividends paid to adult individuals unless such dividends are reasonable in light of that individual’s labour contributions and/or capital contributions to the corporation.

The TOSI will also be expanded to apply to capital gains on property, the income from which was subject to the TOSI. Further, it will also apply (for individuals under age 25) to “compound income” that was previously subject to attribution rules or the TOSI.

These proposals are scheduled to apply to for the 2018 and later years.

Multiplication of the capital gains exemption

A capital gains exemption (CGE) of up to $800,000 (indexed) is currently available to any individual on the sale of qualifying shares of a private company. Issuing shares to family members, either directly or through a trust, is a common way to multiply this tax benefit.

The finance minister has proposed a three-pronged approach that will eliminate the multiplication of the CGE:

Age limit: The CGE will no longer be available to individuals where the gain occurs in any year before the individual reaches the age of 18 years.

Reasonableness test: In essence, this rule will deny the CGE on any gain on the sale of shares if the gain from those shares is subject to the TOSI measures described above.

Trusts: With exceptions for spouse or alter ego trusts the GCE will no longer be available on any gain on a share that is held by a family trust.

These proposals will apply to dispositions after 2017. However, there will be transitional rules that will allow an elected deemed disposition at any time in 2018. The fair market value of the shares would have to be determined, and the qualification criteria for the CGE will be treated as being satisfied if they are met at any time in the preceding 12 months.

Converting a private corporation’s regular income into capital gains

Normally, a distribution of a corporation’s retained earnings is considered a dividend and taxed as such. The top rate on dividends is approximately 44%. Strategies have been used with varying degrees of success to arrange for dividends to be transmogrified into capital gains, which are taxed at 25%. This involves the utilization of the high cost base on shares that have been acquired through a non-arm’s length transaction that had previously triggered a capital gain. Current rules are in place to curtail such “surplus stripping” in limited circumstances. Section 84.1 effectively forces a return to dividend treatment where the capital gains exemption was claimed on the previous capital gain.

The government proposes to extend these rules to any situation where a non-arm’s length transaction involved even a fully taxable capital gain. This proposal is meant to address what has become known as the “pipeline” transaction.

The pipeline has been used extensively in recent years as a post-mortem planning tool to avoid double-taxation where the capital is deemed to occur on the death of a corporate shareholder. Unless the current proposals are altered, the pipeline strategy will no longer be available to an estate.

These proposals will take effect for all dispositions that occur after July 18, 2017. There will be no room for transitional planning.

Holding investments inside a private corporation

One of the long-standing advantages of incorporation is the tax deferral that comes with lower rates on business income. Once the retained income has accumulated over time, the company will have a larger amount available for investment. This has been a great contributor to the retirement of many small business owners. However, it is an advantage that salaried persons or those who don’t incorporate cannot access. Accordingly, the government proposes to eliminate it.

Of all the proposals announced, this is the only one that is not fully developed with draft legislation. The Minister has included some suggested strategies to deal with the issue, each one complex in its own right, and generally altering the system of integration currently in place by eliminating the effect of the corporate tax deferral for future passive investment.

The Minister acknowledges that there currently exists a significant amount of capital invested within private corporations, and it is not his intent to affect these holdings. Any new rules will have effect on a going-forward basis.

These proposals are subject to a consultation period which will end on October 2, 2017. Interested parties should write to the Minister of Finance with any concerns before that date. I suspect that it will be an interesting and eventful autumn for the tax community.

The End of the Tax Mulligan

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What happens when a transaction is undertaken that is planned to be tax-free, but due to an unforeseen error in the execution of the plan, it is subsequently discovered that tax is payable? Until recently, if all else failed, one option was to apply to the courts to allow for “rectification”. That is, since the parties to the transaction originally based their actions on the assumption that the plan was tax-effective, ask the courts to allow them to “redo” the deal correctly to restore its original tax-free intent.

Rectification is essentially not a tax concept. It generally applies where parties to a transaction discover that the legal documents that apply do not accurately represent the agreement or intent of the parties at the time. When both parties agree, the courts are inclined to grant relief and allow for a retroactive correction of the legal documents.

Back in 2000, in the case of Juliar, rectification was granted in a tax context to correct what was essentially an error on the part of the tax planners. Simply put, Mr. and Mrs. Juliar transferred shares to a holding company on the assumption that the shares had a high adjusted cost base (ACB) and no rollover provision was made. When it was subsequently discovered that the ACB was indeed low, they applied to the court for rectification, asking to convert a taxable sale to a rollover under section 85 of the Income Tax Act. The court agreed.

Since then, the case of Juliar has been cited often in cases where mistakes in legalities have created undesired tax results. However, in the recent decisions of Jean Coutu and Fairmont, the Supreme Court has overturned Juliar and has put an end to the idea that rectification can be used as a tool to correct errors in tax planning and its execution.

The court in Fairmont stated:

“…rectification is not equity’s version of a mulligan. Courts rectify instruments which do not correctly record agreements. Courts do not “rectify” agreements where their faithful recording in an instrument has led to an undesirable or otherwise unexpected outcome.”

Juliar was expressly overturned on the basis that the decision resulted in “impermissible retroactive tax planning”.

There is a famous decision (Shell Canada) that stands for the idea that a taxpayer is taxed on the way it arranges its affairs, rather than how it could have arranged its affairs. This concept is often referred to when a legal transaction is executed poorly, resulting in unintended tax consequences. These new decisions are in line with this concept, and they take away a weapon of last resort for taxpayers and their advisors.

Sold your House? Make Sure You Report It!

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If you have sold your home recently, you should take note of the new reporting rules announced by the CRA regarding the principal residence exemption (“PRE”).

The PRE applies on a pro-rata basis based on the number of years you are claiming the house as your principal residence. Form T2091 is technically required to report and claim the PRE on the sale. If you were claiming the exemption for the full period of ownership, then the gain on the sale is fully exempt from tax. The CRA’s policy until now has been that no reporting was required in such a case.

However, for 2016 and future years, this administrative policy has changed. Form T2091 is still not required if the full exemption is claimed, However, the sale must be reported on Schedule 3 of your tax return for the year. You will need to report a description of the property,  the year of acquisition and  the proceeds of disposition. Failure to report the sale will result in the denial of the PRE. However, you may go back and amend your return to report the sale and claim the exemption, subject to possible penalties of $100 per month to a maximum of $8,000.

For Quebec tax reporting, there has never been any administrative policy regarding a fully exempt sale of a principal residence and form TP-274 continues to be required.

Changes for Trusts

If your principal residence is owned by a trust, new rules will apply to you. I outlined the current rules in a previous post.

Under the new rules, only certain specialized trusts are now eligible to claim the PRE. They are alter-ego trusts, certain spousal or common law partner trusts, certain protective trusts or certain qualified disability trusts.

Starting in 2017, any trust that owns a home and does not fit within any of the categories above, will no longer be eligible for the PRE on the sale of the home. Therefore, if the house is sold before the end of 2016, the PRE can still be claimed.

For 2017 and later years, a home that was owned by a trust that no longer qualifies for the PRE will be allowed to calculate the exemption based on transitional rules that would require a valuation of the property as at the end of 2016. The PRE will be available for the “notional” gain up to the end of 2016, while the future growth in value will be subject to capital gains tax.

Anyone who currently lives in a home owned by a personal trust should consult their tax advisor.

Changes for Non-Residents

New rules will also apply to anyone who was a non-resident at the time they purchased a residential property in Canada. Under the current rules, the pro-rata formula that is used to calculate the PRE allows for an extra year (the plus 1 rule) in calculating the exemption. This generally allows for the fact that in a year where someone sells their home, they may own two properties, both of which should qualify for the exemption.

For a non-resident, the plus 1 rule allowed them to claim a portion of their gain as exempt, even though they never qualified since they were non-residents of Canada. Accordingly, for all sales on or after October 3, 2016, the Plus 1 rule will no longer be available to any taxpayer who was a non-resident of Canada in during the year in which he or she acquired the property. There are no transitional rules to this provision.

Death of Testamentary Trust Rules

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The favourable tax rules enjoyed by estates and testamentary trusts until now are almost dead.  Major changes that were introduced in the 2014 federal budget are about to come into effect on January 1, 2016. Don’t be caught off guard.

Estate vs. Testamentary Trust

Until now, most of us have viewed a testamentary trust in basically the same way we would an estate. They both essentially were included in the definition of a “Testamentary Trust”, meaning a trust arising as a consequence of the death of an individual. As such, they were treated in similar fashion under the law, both benefiting from graduated tax rates and both able to have an off-calendar fiscal period for tax purposes.

But now, we must make a distinction between an estate and a testamentary trust.

A testamentary trust is generally a trust that is created by the will of the deceased person. Assets from the deceased’s estate are transferred to the trust for the benefit of named beneficiaries. These assets are then administered by designated trustees. Such a trust could go on for an indefinite period of time, depending on the terms of the trust.

On the other hand an estate is essentially the bundle of assets owned by an individual at the time of death, which is to be distributed by the liquidator to the beneficiaries pursuant to the will within a relatively short period of time. The CRA likes to refer to the “executor’s year”, implying that it should take a year or so to clear the estate and distribute the assets. In many cases it may take longer.

Elimination of Benefits to Testamentary Trusts

Now that we have our terms of reference, the first thing to note is that beginning in 2016, most testamentary trusts will no longer benefit from graduated tax rates, and they will have to switch to calendar taxation years. The only exception will be for “Qualified Disability Trusts”, which essentially is a testamentary trust with a beneficiary that qualifies for the disability tax credit.

There are no grandfathering rules. All existing testamentary trusts will have to cut off their taxation years on December 31, 2015. This could result in many trusts having two tax years in 2015. You should note that the due date for the first of these calendar taxation years will be March 30, 2016.

Furthermore, beginning in 2016, these trusts will:

  • be subject to the highest marginal tax rates
  • will have to make quarterly tax instalments
  • will lose the $40,000 alternative minimum tax exemption
  • will lose the ability to object to an assessment within one year (i.e. the 90 day deadline will apply)
  • will lose the ability to transfer investment tax credits to its beneficiaries
  • will lose the right to apply for a refund after the normal reassessment period
  • may become subject to part XII.2 tax on certain types of income where non-resident beneficiaries exist

Graduated Rate Estates

On the other hand, estates may continue to benefit from graduated rates and off-calendar fiscal years, under certain conditions. Estates that meet the requirements will be known as “Graduated Rate Estates” (“GRE”).

A GRE will qualify only under the following conditions:

  • no more than 36 months have passed since the death of the individual
  • the estate otherwise meets the definition of a “Testamentary Trust” under the law
  • the estate designates itself as a GRE in its tax return for the first taxation year ending after 2015
  • the deceased individual’s social insurance number is provided in the tax return
  • no other estate is designated as the GRE with respect to that individual.

Once 36 months has expired, the estate will no longer be a GRE and will become subject to the less favourable rules described above.

Charitable Donations by a GRE

Currently, a charitable gift made by an estate that was designated by the will of an individual is deemed to have been made by the deceased, and is not deductible within the estate.

Beginning in 2016, a GRE will benefit from new and more flexible rules regarding the claiming of charitable donations. If the estate is a GRE, then such donations may be claimed by:

  • the deceased in the year of death or the preceding year
  • the estate in the year in which the donation is made, or
  • the estate in an earlier taxation year or subsequent 5 years.

Other Changes

Other more complex changes regarding testamentary trusts are coming into effect as well, but a detailed description of these is beyond the scope of this short summary. Briefly, the election to pay tax within a trust, notwithstanding that income is paid to beneficiaries, will be virtually eliminated, unless certain conditions apply.

Finally, for testamentary life interest trusts, such as spousal trusts, upon the death of the beneficiary, a year-end will occur, and any gains or income triggered upon death will be deemed to have been paid to the beneficiary’s estate, making it liable for the taxes on death. This may create a mismatch between the liability for taxes and the ownership of the assets in cases where trust capital is to be paid out to persons who are not beneficiaries of the deceased beneficiary’s estate. A common circumstance where this issue could become a problem is in a case such as a second marriage where children from the first marriage are to receive the capital of a spousal trust upon the death of the beneficiary spouse.

 

2015 Federal Budget Summary

Under the Auspices of the Order of Chartered Professional Accountants of Canada, I am pleased to provide a summary of 2015 Federal budget summary  / 2015 Résumé du budget fédéral. I will also place a link on the Tax Links Page, and it will remain there, along with future federal and Quebec budget summaries for future reference.

What’s Your Tax Issue? Mortgage Refinancing

The Tax Issue:

Our rental property is coming up for mortgage renewal.  Can we take equity out of the rental to pay down on our principal residence?  Obviously then, the mortgage on the rental has increased and the interest is being written off.  Can we do this?

The Answer:

Well, since this is the second time this week I’ve been asked the same question, here’s the answer: NO!

Perhaps I should elaborate.

Under Canadian tax law, interest on borrowed money is deductible only under certain specific conditions. For the sake of bandwidth, I will only mention the most important:

The borrowed money must be used for the purpose of earning income from a business or property.

The emphasis on the word used is intentional. The Supreme Court of Canada, many years ago, laid down the rule that it is the use of the borrowed funds that we look to to determine whether this condition is met. To be more specific, it the direct use made of the borrowed funds. This is a technicality that has both helped and hindered the CRA over the years.

In your case, for example, even though you have dutifully paid down the mortgage on the rental property and now own equity in it, refinancing it is simply borrowing money, using your equity in the rental property as collateral. It is not the collateral that is important, but the direct use of the borrowed funds. Therefore, if you use the borrowed money, as you intend, to pay down you personal mortgage, this will be viewed as money borrowed for personal use, and the interest would not be deductible.

One often recommended strategy, taking advantage of the “direct use” rule, would be to use funds that you currently have invested in savings, such as stocks and bonds to pay down your personal mortgage. Then, refinance the rental property, and use the borrowed funds to repurchase your income-earning investments.

Alternatively, if you remortgaged your rental property and purchased a second rental property, or invested in some other income-earning vehicle, then the interest would be deductible.

2014 Federal Budget Summary

Under the Auspices of the Order of Chartered Professional Accountants of Canada, I am pleased to provide a summary of  Federal Budget 2014. I will also place a link on the Tax Links Page, and it will remain there, along with future federal and Quebec budget summaries for future reference.

 

 

CRA – The Anti-Santa

It’s Christmas time, and that’s got the CRA thinking about gifts – taxing them, that is. The recent case of Shaw v. R. is a cautionary tale for anyone who believes that a gift of cash is never taxable to the recipient.

When a taxpayer tries to take advantage of technicalities in the Income Tax Act (“ITA”) to his advantage, it’s called an abuse of the provisions of the ITA. If the taxpayer is successful, the law is usually changed.

When the CRA taxes an amount of income twice, using the provisions of the law to its benefit, well, that’s just the way it is, end of story. In a previous article, we described a case where the CRA unsuccessfully attempted to tax the same amount of income twice. In the case of Shaw, they succeeded.

Mr. Shaw was a long time employee of a private company called Robert Ltd. Mr. Robert, the owner, apparently did very well and sold the assets of the company to CEDA International. At the time of the sale Mr. Robert had substantial amounts owing to him by his company which had been taxed as bonuses in previous years and credited to his shareholder loan account.

After the sale, Mr. Robert wanted to reward his long-time managers. He sent them each an amount of cash from Robert Ltd., representing $10,000 for each year of service, along with a letter thanking them for their loyal service, and assuring them that these amounts were tax-paid gifts that would be charged to his shareholder loan account and therefore not taxed in their hands. Only one condition was attached to the gift, and that was that they remain employees of CEDA International. Mr. Shaw received $140,000.

Section 6(1)(a) of the ITA provides that all “benefits of any kind whatever” are to be included as employment income if they were received “in respect of, in the course of, or by virtue of an office or employment.”

In this case, the court explained that subsection 6(1)(a) is a broadly worded provision and that the amounts received by Mr. Shaw fell into the category of a taxable employee benefit. The amount was calculated based on his number of years of service, and also came with the condition that he remain employed by the purchaser. Accordingly, the payment, regardless of who made it and what form it took, was made by virtue of Mr. Shaw’s employment.

What is unfair in this scenario is, of course, the fact that the amounts paid had been taxed previously; so in assessing Mr. Shaw, the CRA was essentially successful in taxing the same amount of income twice. It didn’t matter that the person who paid the amount was not the employer, nor did it matter that Mr. Shaw was no longer an employee of Robert Ltd. at the time the amount was paid.

This case should be seen as a warning to those who believe they can avoid tax by directing funds to another person on the premise that it is a gift. The CRA will always look to the underlying reason for any payment and apply the provisions of the ITA accordingly, regardless of whether or not it seems fair to the parties involved.

And no, don’t expect the law to be changed to prevent such an unfair result in the future.

Merry Christmas!

Your Honour…The Dog Ate It!!

In the last edition of Fiscalitems, we dealt with the deadlines and procedures involved in making an application for an extension of time to file a Notice of Objection. Although it seems harsh, the Minister of Revenue and the courts show little leeway in allowing late objections without justification, regardless of the amount of time involved. In this issue, we discuss reasons that may be set forth and whether they would result in acceptance of a late objection

Essentially, the law requires the taxpayer to establish that he was unable to act or to instruct another to act in his name, or that he had a bona fide intention to object to the assessment. A successful request for extension must either show that the taxpayer missed the deadline through no fault of his own, or that he never agreed with the assessment and has always intended to object. Both criteria do not have to be met. However, he must show that he filed an objection as soon as circumstances permitted.

What situations will find sympathy from the courts? Here are some examples:

Physical or Mental Disability: Where a taxpayer has had an accident before the assessment was made, and remained incapacitated for some period of time thereafter, or where the taxpayer suffered an illness during the relevant time, there is clear case law and Revenue Canada commentary that would suggest an extension would likely be granted. The application should highlight the unusual nature of the disability and be precise as to the timing involved.

The above situation would fall under the category of “exceptional” or “unusual” circumstance rendering the taxpayer unable to act in accordance with the law. Other such circumstances which have been accepted by the courts include natural disasters, absence from the jurisdiction and inability to communicate in either of the official languages.

Address Problems: Often, the taxpayer argues that he moved and that he never received the assessment due to an address change. Revenue Canada’s only duty is to send an assessment at the last address made available to the department by the taxpayer. If this address is used, the taxpayer has no recourse. It is his responsibility to notify Revenue Canada of an address change immediately.

Ignorance of Time Limit: Often, a taxpayer may argue that he was simply not aware of the statutory time limit involved, and that he acted as soon as he was informed. The case law here is clear: ignorance of the law is not grounds for allowing an extension. All taxpayers are informed on the actual assessment of the time limit for objection. The courts, therefore afford little sympathy to this excuse.

Reliance on a Professional: In many cases taxpayers plead that they relied on their professional advisor. Here the case law is less clear. In one case, a taxpayer returned from a vacation to find a pile of documents, including a tax assessment, on his desk. Without reading them, he simply delivered the pile to his accountant. The court dismissed the application for extension, citing a lack of special circumstances that rendered the taxpayer unable to act. Furthermore, the simple admission of fault by a professional does not automatically absolve the taxpayer of responsibility.

In order to be successful in placing reliance on a professional, the taxpayer must show that he at all times had the intention to object, was aware of his circumstances, and exercised a reasonable degree of diligence in following up his objection with his advisor. This is particularly true where the taxpayer is a businessman or someone who should be “sophisticated” in his income tax affairs.